I start by outlining the purpose of financial stability.
Since the 2007-8 financial crisis, “financial stability” has been all the rage. We must prevent another crisis: we must solve the problems that make our financial system “unstable”.
But what exactly do we mean by “financial stability”? Most people would define a stable financial system as one which doesn’t fall over when it is hit by a major shock; doesn’t cost us huge amounts of money in repair bills when it is hit by a major shock; doesn’t draw in its horns and refuse to lend when the going gets tough; doesn’t become over-exuberant and lend far too much at too high a risk when times are good.
I continue by summarising the measures taken since 2008 to ensure financial stability in the Western world, and particularly in Europe. I then go on to trace the history of the Greek crisis of 2010, the Eurozone crisis of 2011-12, and the second Greek crisis of 2015. I draw out some of the mistakes made and lessons learned from each of these. I then turn to the questions that the resolution of these crises have raised for the future of the Eurozone and of non-Eurozone countries within the EU. I conclude:But financial stability is not an end in itself. Rather, it is a means to an end. What we really want is a financial system that is stable, resilient and resolvable, so that it can support the real economy.
The 2008 financial crisis taught us that financial insitutions and markets cannot self-regulate; that finance is intrinsically bound up with people’s economic welfare; and that the price of failure adequately to supervise and regulate the financial system can be extremely high.
The 2012 Eurozone crisis taught us that central banks are the linchpins of financial stability. They have the ability to prevent or contain damaging runs and solvency crises; they also have the ability to create them. They are inherently political institutions, and none more so than the ECB, despite its supposed independence. And when they decide to act destructively – or do so out of ignorance – the economic fallout can be terrible. Central banks bear huge responsibility.
As we enter the third phase of the Great Financial Crisis – the ending of the Asian growth miracle - the lesson to be learned already appears to be – what are the limits of central banks, and what is the (new) role of fiscal policy in a low-growth, low-inflation, low-interest rates world?
The whole paper is far too long for a blogpost, so I've linked it here as a pdf.